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Author: Stoffel67 Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 76394  
Subject: How to account: pensions vs. cash accts? Date: 1/2/2004 9:22 PM
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I apologize if this as been answered--my search didn't turn up anything (which could point to my feeble search skills).

Wife and I are celebrating our first New Years together (married last July), and I'm in charge of the finances. The budget is still in flux, as we're grappling with how much to save; right now we're erring on the side of "as much as humanly possible".

We started off last year with a bang by fully funding our Roths, and funding the 2002 Roths to the max too. I keep track of all these "cash account" type investments in an Excel spreadsheet, including my company 401(k). Now, through various searches & using some common sense (warning--common sense may be as faulty as search skills), it seems to me that I can take an anticipated rate of return, subtract inflation, and add that interest along with our expected future contributions to arrive at how much we'll have at our fabled "retirement age". I'm pretty confident on this part here, but feel free to correct me.

Here's the rub--she's a school teacher, and she has a defined benefit plan as part of her retirement--she no longer contributes to social security. I'm in the private sector, so I have social security benefits due at retirement as well. But these aren't like "cash account" investments--they give a monthly benefit that gets larger the more we work.

So how exactly would one account for this? Do I figure, "Well, I might live for 25 years after my retirement, so a monthly benefit of $1000 is kinda worth $X in cash if you account for interest and inflation over 25 years"? Or do you do the opposite and try to represent the cash accounts--401(k), IRAs--as what they would be giving monthly if we wanted to deplete them in 25 years?

In engineering terms, I'm trying to figure out how to normalize cash account units to pension units, or vice versa, and which if any is a common practice.

Thanks for your time, any hints will be greatly appreciated.
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Author: babyfrog Big red star, 1000 posts Old School Fool Home Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38348 of 76394
Subject: Re: How to account: pensions vs. cash accts? Date: 1/3/2004 12:41 AM
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Hi, Stoffel67,

it seems to me that I can take an anticipated rate of return, subtract inflation, and add that interest along with our expected future contributions to arrive at how much we'll have at our fabled "retirement age". I'm pretty confident on this part here, but feel free to correct me.

In the financial planning training materials that I'm studying from currently, the way that they handle inflation and future dollars is with a division equation. Presume that you expect 8% return on your investments and a 3% inflation rate. The equation to tell you your after-inflation total return would be (1.08/1.03)-1 = 0.0485 = 4.85%. For most values in the range of expected investment returns, your equation, which sounds more like 1.08 - 1.03 = .05 = 5%, would be a decent first cut approximation, but over the life of a long term career, that extra .15% difference in compounding assumptions can make a big difference. The reason why the first equation is better is because you're calculating future dollars against future dollars. In other words, with 3% inflation, because it will take $1.03 in a year to buy what $1.00 will buy today, the $1.08 you hope to have earned by then will only be worth $1.08/$1.03 = $1.0485 of today's spending power.

In engineering terms, I'm trying to figure out how to normalize cash account units to pension units, or vice versa, and which if any is a common practice.

When you retire, instead of working for your money, you will hopefully be in a position where your money will work for you. For that to work, your assets need to through off a cash flow stream, either through asset sales or through dividends, interest, or other cash distributions. Your retirement assets are a means to an end - that end being a cash flow stream able to cover your chosen retirement lifestyle for as long as you're allowed to live on this Earth.

As such, the way I look at the problem is as follows: "If I want a $50,000 per year lifestyle in retirement, then I'll need my pension + social security + retirement accounts be able to pay out a total of $50,000 per year." If Social Security will pay out $5,000 per year, and the pension will pay out $25,000 per year, then that means the retirement accounts need to pay out $20,000 per year. And, of course, inflation doesn't just stop when the paychecks stop, so the basket of assets and pensions needs to be sufficient to handle the ravages of inflation.

On a very much related note, the CPI, the most widely recognized measure of inflation, provides a view of inflation throughout the general economy. For seniors, however, the inflation picture is much worse. While the price of goods may be stagnating, the price of services, especially medical services, is skyrocketing. And in general, seniors tend to have a higher need for services, especially for services of the medical variety, than do younger people. So while Social Security has a Cost Of Living Increase and some pensions do as well, those increases may be pegged to an inflation rate that is not necessarily reflective of the needs of a Senior Citizen.

Well, I might live for 25 years after my retirement, so a monthly benefit of $1000 is kinda worth $X in cash if you account for interest and inflation over 25 years"?

There are two ways to look at that question of a life-long cash flow - a forever account and a draw down account. The draw down perspective says "we're going to die, let's spend it all and die broke". The forever perspective says "we're going to die, but we don't know when, and we'd rather not live out our last days in destitution."

The draw down version provides a higher initial cash flow, but the assets are scheduled to be reduced and eventually extinguished. The forever version provides a lower initial cash flow, but the assets are scheduled to last long enough to be passed on to heirs. In reality, the longer one expectes to live in retirement, the closer the two methods become. For example, let's take a hypothetical person with $500,000 in assets, no other form of cash flow, and a world without inflation.

If that person can earn 5% per year on those assets, that person can take out a $23,809.52 payment at the beginning of every year, forever, from a forever account and never run out of money.

If a person who retires at 67 expects to live to see 92 (25 years), that person can view the assets as something to be drawn down, instead. With the same assumptions as above, but a desire to draw the assets down to zero at death at age 92, the person can take $33,786.88 at the beginning of each year, and run out of money after 25 years. Which is all fine and dandy if one plans to die at age 92 or earlier, but if a person happens to live to see 100, those last eight years will be painful...

In this example, the draw down account paid out about about 41.9% more than the forever account, but the higher initial cash flow needs to be balanced with the fact that at age 92 the money is gone, and finding work at that age is not an easy task... The difference shrinks dramatically the longer a person expects to live in retirement. Take the same hypothetical person in the same fictional world, with the same $500,000 assets, the same 5% expected return, and the same life expectency of 92. Only instead of retiring at 67, this person takes advantage of a generous company's early retirement package and leaves at 47. Now, instead of 25 years in retirement, this person is looking at a 45 year retirement.

The forever account will still pay out the same $23,809.52 at the beginning of every year. The draw down account, however, will only pay $26,791.30 at the beginning of every year. So by anticipating an extra 20 years of retirement, the difference in payments drops from 41.9% to around 12.5%. And the draw down account will STILL fall to zero at age 92, whereas the forever account will still have $500,000 in it at age 92, in case the person happens to live longer.

Personally, I have no idea when I'll die, but I hope it doesn't happen for a very, very long time. I hope to retire early, if at all possible. I'm also quite conservative with my estimations, so I prefer to think and plan for my retirement with the 'forever' account model.

---------

You can certainly choose whatever model you'd like, including some that I haven't mentioned here (such as the "Safe Withdrawl Rate" model they discuss ad infinitum on the "Retire Early Home Page" board). My point was not to dictate the path you must take but rather to share with you my personal perspective and practices on the issues you raised. I hope it was at least minimally helpful.

Best of luck to you,
-Chuck

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Author: ptheland Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38349 of 76394
Subject: Re: How to account: pensions vs. cash accts? Date: 1/3/2004 1:14 AM
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So how exactly would one account for this?

What are you trying to accomplish in your accounting? Determine your current net worth? Find out how much you are earning currently? Figure out when you have accumulated enough to retire? Determine your projected retirement income?

Any method of accounting will have some strengths and weaknesses - some ways of showing information that are more useful than others. Once you know what you want to do with your accounting, then you can determine which method makes the most sense for your purposes.

--Peter

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Author: Landog Three stars, 500 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38350 of 76394
Subject: Re: How to account: pensions vs. cash accts? Date: 1/3/2004 1:50 AM
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Hi Stoffel, and welcome aboard!

If I read you right, you are trying to determine how to value the future guaranteed payments for your wife's Teacher's Pension.

One way to do it is to discount the present value of future funds. If her pension is of the government type, I would use a low discount of say 6%. In effect, you would be treating this as a type of bond income.

For example:

If she's still working and you know that if she retired today, she would receive "x" dollars per year, then the present value would be (x/.06) I assume that the longer she works, the better the pension gets, so you'll want to update this yearly until retirement.

So if she retired today, and would receive 30,000 per year, then the present value of this future income stream would be:
30,000/.06 = 500,000

If the pension was coming from a source other than the govmt, I would discount it a bit higher, depending on the company.


Not to bring up an awkward issue, but you should both have an idea of what the income stream would be like if "something" happened to one of you. If the pensions cease because of a death, you'd want to have enough insurance to cover that lost income steam.

Sorry, didn't mean to go there, but it's just as important.

Again, welcome!

Landog


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Author: OxBeaux Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38352 of 76394
Subject: Re: How to account: pensions vs. cash accts? Date: 1/3/2004 8:19 AM
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While the price of goods may be stagnating, the price of services, especially medical services, is skyrocketing. And in general, seniors tend to have a higher need for services, especially for services of the medical variety, than do younger people.

While I am not a great believer in insurance, I will always carry Medigap and long term care insurance.

OxBeaux

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Author: Stoffel67 Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38356 of 76394
Subject: Re: How to account: pensions vs. cash accts? Date: 1/3/2004 7:00 PM
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Wow, such great responses! Thanks all!

First some general comments about where we are currently, since my question spawned other questions. I have a plan, with just our cash accounts, on how they'll grow toward retirement. My spreadsheet is set up with one-row-per-year, and using these assumptions:
- Contributions will grow by $500/yr
- I'll earn 10%/yr till 2010 (when I hit 35) since I'm 100% in stocks right now, then the rate will drop by 1/6% per year after that since I'll start diversifying toward bonds; I'd hit 5% at age 65.
- I have a column for a single inflation-adjusted dollar, starting 2002 and reducing by 3.5% each year (dollar = last_year's_dollar/1.035).

With these assumptions and our starting point, we'd have $6.9 mln in 2040, when I'll be 65, or $2.3 mln in 2002 dollars (my dollar in 2040 is worth $.27).

Now, the problem here is that I was counting my wife's pension (she's a California Teacher, by the way, so we're talking STRS (www.calstrs.com) since that was a question) as just part of the lump sum we had in our contributions since I really don't know how else to plan for it. Obviously, though, I'm not going to be able to control her contributions like I'm controlling my 401(k), so the gain I get on that isn't realistic.

babyfrog/Chuck:
I think that answers your question on inflation--I think I'm doing it the way you suggest, though in a round-about way.

It sounds to me like you're advocating normalizing my cash accounts to what I'd get out of them monthly in retirement--e.g. normalize to cash flow. That sounds good to me.

I hear you on the draw down vs. forever accounts. Sounds like I'll have to start looking into the "retire early" board--I have no intention of stopping work before I'm 65, but it sounds like folks there are interested in the same things I am.

Thanks for the very long response, it was very helpful.

ptheland/Peter:
What are you trying to accomplish in your accounting?
- To formulate my expected financial picture at retirement
- To predict the amount I need to save to get there, e.g. a retirement plan
- To be able to track how I'm doing toward accomplishing the retirement plan

Determine your current net worth? Find out how much you are earning currently?

Nope, got that all down. I am a powerhouse of budgeting/cash flow spreadsheets. It's the future savings planning that's giving me headaches.

Figure out when you have accumulated enough to retire? Determine your projected retirement income?

I'll probably retire at 65, though The Plan is to move out of the private sector and into a teaching job once it's feasible. So I guess "yes" to both of those questions.

Landog:

Yes, you read me half-right, and you answer compliments Chuck's answer; I've also heard about taking 6% of a cash asset at retirement as the starting cash flow, so I guess your suggestion is just the same thing in reverse. It makes sense, but I think I might want to normalize to cash flow instead. It's easier for me to visualize the knobs to turn on the calculations to figure out how cash flow I can get out of a fixed sum than vice versa.

As far as insurance goes, we're still not contributing a dime to my wife's 403(b), and we have a ways to go to build up an emergency fund. For the time being, we have a term policy; we'll probably look at converting to permanent once we fully fund the 403(b) and have that e-fund stocked.

Thanks again for all the answers!

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Author: ptheland Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38358 of 76394
Subject: Re: How to account: pensions vs. cash accts? Date: 1/4/2004 12:32 AM
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I'll probably retire at 65, though The Plan is to move out of the private sector and into a teaching job once it's feasible.

So it sounds to me like what you need to know is: 1) how much you project that it will cost you to live during retirement, and 2) how much income you have to spend in retirement. Once 2) exceeds 1), you are ready to retire.

Given that, I would not try to convert the annuity-type retirement benefits (social security and defined benefit pension) into an equivalent lump-sum. Instead, I'd total your accumulated assets, calculate what spendable income would result from that total (based on estimated earnings and your willingness to invade the principal), then add in the SS and pension. That would give you your total income in retirement.

--Peter

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Author: Stoffel67 Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 38365 of 76394
Subject: Re: How to account: pensions vs. cash accts? Date: 1/5/2004 11:19 AM
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Yup, and you're agreeing with Chuck here. The more I think about it, the more that sounds like the way to go. This gives me a great starting point, thanks all.

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